Perverse Incentives

For anyone interested in making the world a better place, economics boils down to just one phrase: Incentives matter. Set up the right incentives--be they bonuses, subsidies or stock options--and you can get people to do nearly anything.

But be careful: If you're not paying close attention, the incentives that you set up can have perverse consequences--even, in some cases, causing people to work against the goal you were trying to achieve. On Wall Street, year-end bonuses made sense--until traders discovered they could reap million dollar rewards by hiding billions of dollars of risk.

On Main Street, perverse incentives are commonplace. Take, for instance, Mr. Jeremy R. Shown, a father of six who blogs at Rhymes with Clown. One evening, Shown and his wife decided to incentivize their kids to clean up their toy-strewn rec room. So they offered the kids candy. This achieved the immediate goal perfectly, with the kids cleaning up the rec room in just a few minutes.

Unfortunately, the couple had also unintentionally set up a perverse incentive. While each kid was sucking on the piece of candy that he or she had earned, their 4-year-old boy walked up to his 6-year-old brother and whispered conspiratorially, "Tomorrow, we have to make another mess so that we can get another one of these."

The labor markets are strewn with similar cases of perverse incentives. Take, for instance, the 19th century paleontologist who paid local Chinese peasants for every fossil fragment that they brought in. This led the locals to smash the fossils that they found into multiple fragments before bringing them in. Doing so maximized their payments.

IBM
had a similar problem when it decided to pay its programmers by the line. They responded by maximizing the number of lines they wrote.

Budgeting also leads to lots of incentive problems. Suppose that you're promoted to section chief and figure out a way to cut so much waste that you come in 15% under budget.

How does the typical bureaucracy react? Do they give you a medal? Do they give you a raise? No. They cut your budget for the following year by 15%.

And where does all the money that you saved end up? In departments whose managers were lazy, sloppy and came in over budget.

This sort of incentive structure is what makes it so hard to reduce government waste.

Perverse incentives often arise when governments interfere with markets and tinker with prices.

Medicine provides many examples due to the fact that governments try to set prices and reimbursement rates on nearly everything physicians do.

Ever wonder why your doctor spends so little time asking you what's wrong but seems very happy to order a dozen or more diagnostic tests that you don't have any particular interest in?

It's not because he thinks that the tests will tell him more about your condition than he could gather by talking to you. It's because Medicare and Medicaid set relatively high reimbursement rates for diagnostic tests but relatively low reimbursement rates for time spent talking with patients.

This incentive scheme also stymies the practice of preventative medicine, which requires spending a lot of time talking with patients. Under the current payment scheme, there is no encouragement for the talks that could forestall illness. Instead, the government only pays doctors to treat patients after they have fallen ill.

Which perverse incentives are most likely to be corrected? Economist Thomas Sowell takes a clear stance:

"Human beings are going to make mistakes, whether in the market or in the government. The difference is that survival in the market requires recognizing mistakes and changing course before you go bankrupt. But survival in politics requires denying mistakes and sticking with the policies you advocated, while blaming others for the bad results."